US$369.6 million in defaults at apparently cash-rich firms expose flaws in mainland Chinese auditing practices


by Xie Yu
Three mainland Chinese companies have missed a combined 2.5 billion yuan (US$369.6 million) in debt repayments over the past two months despite apparently high cash holdings, a development that has exposed deep flaws in the auditing and financial disclosure practices in the country.

Kangde Xin Composite Material Group, a Shenzhen-listed new material producer, failed to pay a 1 billion yuan local note due on January 15 because of a liquidity crunch, according to the company. Yet, as of September end, it had 15.4 billion yuan in cash and equivalents, more than double the amount of its short-term debt, according to a company financial report for the third quarter.

Shandong SNTON Group failed to repay a total of 398 million yuan by late December 2018, even though it had reported a cash balance of 4 billion yuan by the end of June 2018. Reward Science and Technology Industry Group, meanwhile, defaulted on bonds worth about 698 million yuan in December, despite having 4.2 billion yuan in cash by the end of September.

“Corporate defaults are usually driven by insufficient liquidity, but these companies’ stated cash balances cannot explain the non-payments,” said Renee Lam, regional credit officer at Fitch Ratings.

“Uncertainty over the accuracy of the companies’ books and disclosure of pertinent information is ultimately related to governance and accounting quality.

“International bond investors have become more receptive of Chinese issuers choosing not to hire one of the ‘Big Four’ international accounting firms over the past decade. However, the quality of domestic auditing is variable. It is not unprecedented for domestic audit firms to be reprimanded for shortcomings,” she added.

The defaults raise questions about the companies’ reported cash balances. They reported their restricted cash balances in line with China GAAP, an accounting standard that mandates disclosures on cash encumbrances in line with international standards, according to a report issued by Fitch Ratings last week.

The companies, however, may not have made sufficient disclosures about the status of their funds, if these could be freely used, or if there were “agreements with lending institutions to keep sums in designated accounts to support facility access”, according to the report.

On Friday, Kangde Xin Composite said it would delay its reply to a regulatory inquiry made by the Shenzhen bourse because the “workload to answer the questions is too big”. The bourse had on January 16 asked about the status of the 15.4 billion yuan in cash recorded in its financial report. The inquiry included specific questions such as the location of the money, whether it had been put up as collateral, if its use was restricted by other means, or if the company had faked its financial data.

A day earlier, a spillover had driven down the bond price of Kangmei Pharmaceutical, a company listed in Shanghai, to a record low of 42.1 yuan from 73.3 yuan on Tuesday. Its share price also sank to a six-year low amid a sell-off – all because of concerns that the apparently ample cash flow on its books was untrustworthy.

Foreign governments, including those of the United States and European Union member states, have been urging China to bring its accounting standards closer to global convention. Concerns about the credibility of Chinese companies’ financial disclosures have been flagged from time to time by authorities in the US. In December 2018, the US Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board, which regulates auditors, reminded investors of the obstacles regulators still faced in inspecting China-based auditors.

Some US politicians have even asked SEC Chairman Jay Clayton for legislation that would give the commission the authority to ban and delist companies from countries such as China that do not sign onto an access reciprocity agreement with the US audit regulator.

Accounting firms colluding with clients to fake financial data for fundraising purposes is not a new problem. In February 2018, a Shanghai court found audit firm Reanda Certified Public Accountants guilty of faking financial reports for Zhonghengtong (Fujian) Machinery Manufacturing, helping it to issue a private 100 million yuan bond in 2014 by eliminating debt worth 20.3 million yuan. The fraud came to light in 2016, when the company defaulted on the bond. Four accountants were found guilty but have appealed against their jail sentences.

A total of 40 accounting firms are qualified for auditing securities and futures issuances in China. “Usually, it is very difficult to define the responsibility of auditors,” said Hu Hongwei, partner of law firm Dentons in Shanghai. “In some cases, auditors are deceived by the company. Sometimes, auditors are careless. Only in some rare conditions can auditors be held accountable for colluding with companies to fake financial data … to some extent, it makes the cost for committing a crime small,” he said.

Of course, financial fraud is not restricted to China. Ben Zhu, a credit investor based in Hong Kong, said: “The mainland audit firms are held accountable because these problems take place with mainland companies on the onshore market. But even foreign institutions like the ‘Big Four’ are not above scandal. Just look at the case of China Forestry.”

In 2017, regulators in Hong Kong sued Standard Chartered and UBS Group along with KPMG for a problematic listing by China Forestry Holdings, and noted that the prospectus and financial reports, audited by KPMG, constituted “market misconduct”.

Kangde Xin Composite defaulted on another note worth 500 million yuan on Monday last week, and was on Wednesday put on the risk alert list by the Shenzhen Stock Exchange after its bank accounts were frozen.

Sources close to its creditors said about 10 billion yuan of its cash was held by its largest shareholder, Kangde Investment Group, while the remaining 5 billion yuan could have been used as deposit for stock pledge based lending.

Kangde Investment owns a 24.05 per cent stake in Kangde Xin Composite, and 99.45 per cent of its share has been pledged, according to earlier filings. When share prices drop, borrowers need to increase their deposits with their lenders, which might account for the 5 billion yuan.

“It is not illegal for the biggest shareholder to pledge its shares,” said Sun Wujun, a professor at Nanjing University Business School. “The problem is, it is a common practise by mainland-listed firms to cover this kind of behaviour. In the past, they could avoid accurate disclosure about the use of cash, because all kinds of alternative financing channels would provide easy short-term liquidity,” he said.

But since last year, when Beijing started cracking down on the shadow banking sector, these problems are being widely exposed, and investors should brace for more similar cases, said Sun.courtesy